ROAD TO RECOVERY PLAYBOOK

After recording two double-digit drops in equity prices over the last three trading days, the global pandemic
of COVID-19 has sent world equity markets into bear market territory. The result is a cumulative 30% drop
in the S&P 500 Index in just under 30 days. Though daunting, once the market finds a bottom, which is
where the index begins to consistently move higher than the previous market low—and we believe it is
“when” not “if” the market finds a bottom—it may provide an attractive opportunity for long-term investors
to consider adding risk to portfolios.

Given all the uncertainty, which can raise questions and result in emotional reactions from many investors,
LPL Research believes that it is important to take a systematic approach to determine when that bottom
might be found, enabling markets to reverse course and move higher. To guide long-term investors toward
what to focus on in order to hone in on that timing and those potential buying opportunities, LPL Research
has compiled a Road to Recovery Playbook.

LATEST PERSPECTIVE

These are extraordinary times. The global pandemic has caused significant worldwide economic disruption,
driving stocks into a bear market for the first time in over a decade and sending U.S. Treasury yields
plummeting. Major US cities have effectively gone into quarantine, entertainment and sporting events have
been cancelled, large gatherings of people have been banned, schools have closed—and the list goes on.
While the health of those close to us remains our top priority, as investors, we also must try to assess the
economic and market impacts. Recession odds have risen sharply, as it is becoming clear the impact on
economic growth and corporate profits—though temporary—may be significant. Powerful monetary and fiscal
stimulus actions and more aggressive containment measures may likely help mitigate the impact, but it’s tough
to see the other side from where we sit today.

THE PLAYBOOK

Before getting to our investor playbook, we would first encourage long-term investors to consider staying with
your long-term investment plans.
We believe having a systematic playbook to follow can help us manage through these tough times.

When
those difficult times are caused by bear markets, a playbook can make clear what to watch as “leading
indicators” of a potential market bottom that may signal the start of a sustained move higher. This playbook
may help ease concerns by taking some of the emotion out of investment decisions and facilitating a measured
approach. We all want to know when and where the market will bottom, the likelihood of a potential recession,
and when the outbreak will be contained. These are extremely difficult questions to answer—but this playbook
is designed to provide some clarity

Foremost, we need to identify the most important signals, shown in Figure 1, that can help us determine when
the market may find its footing. It’s important to note that having all five of these signals turning positive is not
required before attractive entry points might be considered. Currently, the majority of these signals are either
already or close to signaling that a potential bottoming process may not be that far off.

Key signals for the playbook

Confidence in the timing of a peak in new COVID-19 cases in the United States. The number of new US cases continues to rise, and we don’t know when or at what level they will peak. Based on the experiences in China and South Korea, we think the peak is coming within the next month. However, the experience in Italy suggests perhaps it could take longer. The key is not to wait until the peak in new cases has materialized, but rather developing the confidence in the predictability of the pandemic’s outbreak path using sophisticated epidemic models, like Farr’s Law, which has successfully modeled disease spread through populations in past pandemic episodes. We see confidence in the timing of a peak as a major milestone in the stock market bottoming process as in past pandemics, the market has usually found its trough in prices tied to the stabilization of new cases, not necessarily the visibility of declines. We continue to monitor new cases daily and watch for signs of what path the US may take to.

Visibility into the probability and severity of a US recession. We won’t know for sure if the US economy has entered a technical recession for many more months—since you only know you’re in a recession in hindsight. However, we will likely see data that indicates the timing and severity of a potential recession very soon. We will be watching the most timely data points to help gauge the depth and severity of a possible recession, including the March Institute for Supply Management (ISM) surveys, consumer confidence, jobless claims, and the Leading Economic Index, among others.

Has a recession already been priced into markets? We think we are already there on this one. A nearly 30% decline in the S&P 500 Index from the February 19 record high is consistent with a typical recession. We can also point to valuations. For example, if we cut current S&P 500 earnings by 10% and apply a reduced price-to-earnings ratio (P/E) of 15, we get to an S&P 500 level of about 2,200, which we think is a reasonable recession-level downside target. We can also look at the equity risk premium, which is the difference between the earnings yield (earnings-to-price ratio of E/P rather than P/E) and the 10-year US Treasury yield. At over 5%, the equity risk premium is nearing the 6% level seen at the market lows in 2008–2009.

Sentiment and technical analysis indicate limited number of sellers remaining. To assess whether most aggressive sellers have been forced out of the market, we can look at investor surveys or technical indicators. Survey data such as the CNN Fear & Greed survey and the American Association of Individual Investors (AAII) survey reflect some of the most negative readings ever registered, a potential contrarian signal that most of the selling pressure could be behind us. Additionally, a historically high number of stocks are oversold, potentially a bullish combination when combined with the extreme negative sentiment.

Will policymakers’ response be sufficient to restore confidence? We think we are getting close to getting this signal. The Federal Reserve is pretty much “all in,” having effectively cut interest rates to zero while adding another round of quantitative easing (buying bonds) and more liquidity to ensure credit markets function. We have a very aggressive monetary policy, but what is needed now is a strong fiscal policy response, including targeted support for individuals and businesses most impacted by the crisis. We expect meaningful progress to be made this week in Washington, D.C., toward what could eventually exceed $500 billion in total stimulus.

Revised economic forecasts

In response to the impact of the pandemic on the economy and markets, we have updated our forecasts for 2020 [Figure 2]. We have lowered our gross domestic product (GDP) forecasts for the US, emerging, and developed international markets, as well as global GDP. These forecasts reflect a greater than 50% chance of a short-lived economic contraction in the United States. We believe the strength of the US economy prior to the outbreak may help it weather the storm.

We have also lowered our forecast for the 10-year Treasury yield, S&P 500 earnings per share (EPS), and year-end S&P 500 fair value.

We have provided our base case as well as a potential bear case, given the amount of uncertainty. Our base case GDP forecasts are all slightly below consensus expectations, based on Bloomberg forecasts where available.

Finally, our revised year-end 2020 fair value target for the S&P 500 of 3,150–3,200 is based on a P/E of 18, supported by lower interest rates and S&P 500 EPS in 2021 of $175, a slightly above-average earnings growth forecast for next year coming off potentially depressed profits in 2020. Investors may have to wait longer for those earnings in 2021 to come through, and the outlook is clearly uncertain, but we have more confidence in next year’s earnings than this year’s. In a recession scenario in which earnings may be heavily impacted, we may see a downside scenario on the S&P 500 of around 2,200 or potentially lower.